How do I set terms for a seed round?

Two weeks ago, I answered a question from a Dear Founder reader who was launching a startup and looking for advice on raising money, giving equity, managing costs and building something that matters . It was a lot to cover in one piece, so I decided to do a series of posts to focus on these ideas. Last week I provided more specific guidance on how to set a valuation . This week, in the third and final post in this series, I focus on how to set terms for a seed round. This response was written by Jonathan Pines, a managing director at the Webb Investment Network, and originally appeared in the book, Dear Founder .

How do I set terms for my seed round?

-Founder who has someone interested in investing in the business

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Dear Founder,

First of all, congrats! If someone wants to invest in your business, then you are already off to a great start. Now you just need to agree on the details, structure your round, and build a positive relationship. Here are a few things to keep in mind as you go through this process.

Do your research.

• Read up on round structure. Many early-stage rounds are done with convertible notes or SAFEs. Do some reading to understand how these contracts work, and look up common terms like cap, discount, pro rata, liquidation preference, and mfn. The short answer is conversion_price = minimum[cap/pre_shares, equity_price*(1-discount)].
• Do the math and create a model! Convertible note math is tricky, and the results are not intuitive. Build a simple spreadsheet to understand how conversion will work and include all rounds through your Series A. Calculate your dilution and look at how the share price changes from round to round. You can find an example simplified model at goo.gl/tVaIQ1 or create your own.

Check your assumptions.

• What is your next round? Your next stage might be a Series A, another early-stage round, or profitability. Many companies raise more than one early-stage round, so experiment with this—especially if you are raising a smaller seed round. Also ask around to estimate the size and price of your Series A (as a rule of thumb, the size will be 20-30% of the post-money valuation).
• What are your milestones? Talk to founders and investors and try to get a sense for what it will take to get to that next stage. It might be a certain amount of revenue, usage, team, or something else. Your milestones should be both realistic and sufficient: you don’t want to run out of money before hitting them, nor do you want to get there only to find out that you set your targets too low to raise the next round.
• How much money do you need? How much time, team, and resources will you need to hit your milestones—and how much money will that take? Be conservative and leave some breathing room. Things usually go slower than expected, and raising the next round will take time too. We usually advise our companies to aim for at least 18 months of runway in a seed round. If this is not possible, focus on your milestones and add some extra buffer.
• Are you sure? When you are just getting started, it is easy to believe that your company will be a big success. In reality, it usually takes more time and money than you expect and the next round is usually harder to raise and smaller than you hoped. Gather a few data points, double check your assumptions, and don’t assume you will be an outlier.?

Choose a fair price.

• Consider your dilution. Many seed rounds bear 20-25% dilution, meaning the seed investors will own that much of your company before the next round. Sometimes this can be as low as 15% or as high as 30%, and in unusual cases outside this range too. There are no hard rules here, but this can provide one data point on where to start.
• Leave room for upside. Your first investors are taking a risk and supporting you early, at a stage where most companies will fail. Treat them well and set them up for success in the next round with a price increase. If you are close to your milestones, then a small step up might make sense. If you are just getting started and aiming for $2M revenue in 18 months, then a bigger jump is in order.
• Market pricing trumps all. Ultimately, the terms are set between you and your investors, and anything goes as long as you agree with them. If you have a lot of interest, you can be choosy. If not, you may need to take whatever you can get. Either way, try to stay within a reasonable range. You don’t want to give up too much of your company, and you also don’t want your investors to get a raw deal by paying the same price as the next round (or to have a price decrease, which can cause other issues).
• Work together to set terms. If you don’t have significant commitments to invest in your company, keep an open mind. If you try to set terms up front on your own (or with someone who is writing a tiny check), you may create mismatched expectations. Work together with your early champions to set terms that make sense for everyone and set the tone for collaboration.

Think about the long term.

• Choose your partners carefully. Good investors will be great partners for you in the future, and they will help you grow your company and raise future financing. Ask around about their reputation, and their willingness and ability to help.
• Prioritize what matters most to you. Some founders want mostly financial support, and others are focused on getting help and a good network from their investors. Some want to minimize dilution, and others want extra runway. If you are over-optimizing terms, be mindful of any tradeoffs you may be creating. Once you decide what is top of mind for you, don’t sweat the small details.

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Every week I respond to a new question. Ask me your question in the comments section.

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